Category Archives: Buy the Cheapest Business

In a 2004 interview, Bruce Greenwald, Columbia business professor and value investing expert, spoke about micro-cap investor Paul Sonkin. Value investors continue to track Sonkin because of his excellent reputation and track record. During the 4 1/2-year period preceding the interview, Greenwald points out that Sonkin generated average annual returns of 25% compared to 3% for the general stock market.

What is fascinating is that Greenwald points out that the vast majority of Sonkin’s returns came from buying additional stock if an investment declined after the initial purchase. Greenwald explains that for this to work, an investor needs to have a great deal of confidence in his valuation methodology. Other prominent value investors have also advised buying additional shares if a security declines after your initial purchase.

The key here is knowing what you are doing. Greenwald also states that, in the case of Sonkin and Walter Schloss, their investing process included selling a portion of their shares on the way up. Of course, if you do not have a robust valuation methodology or simply bought shares because a given security was going up in price and you figured you could offload them to someone else at a higher price, this strategy is unlikely to work. You’re more likely to do just the opposite and dump your shares out of fear if your position moves against you.

Investing like Sonkin and Schloss also requires only investing when you have a margin of safety.

Here the relevant part of the interview:

Greenwald: . . . And the third thing you have to have is discipline and patience. In the story I’m going to tell you about discipline and patience and the value strategy is about Paul Sonkin — his name is on the book — who was put into business by a set of value investors, myself among others. He’s just performed phenomenally. He’s been in four and a half years, and you can’t really tell on a four-and-a-half-year record, but his returns after fees have averaged about 25% with a market around 3.

TMF: That’s incredible.

Greenwald: He has a strategy of very, very small stocks. So if he buys half a million dollars, then he has to file a 13D [required when you buy more than 5% of a company’s stock] in some of these companies. But that means he’s the only one there. So he satisfies the first criteria. He’s got the basic valuation methodology. But one of the things we did in looking at his trades is that we looked at what he would have made if, when he made the first purchase of the stock — the first time he bought it — he just bought it there and he’d sold it at the first sales. So that he’d just done one buy decision and one sell decision, as opposed to buying it first, finding out, oops, the stock has continued to go down, but continuing to buy on the down side, having confidence in your valuation judgment. Of the 25% return, about 22% of it came from purchases at lower prices than the initial purchase. We’ve got Walter Schloss’s archives, and it looks like — we haven’t got the numbers yet — a large percentage of Walter Schloss’s returns have come also over time from knowing that you’re buying something worth buying. And then when it goes down, not getting frightened and dumping it, but continuing to buy. And then selling on the way up. Looks like that does a lot better than just averaging down. [emphasis added]

Greenwald: That’s exactly right. But notice what that depends on. You have to have confidence in your valuation. And you have to have the discipline to stick with it, that if this is a good stock and nothing has changed about the underlying value of the company, then if it’s a good stock at 8, then it’s a better stock at 4, rather than people who will see a stock go from 8 to 4 and say, “Oh crap, something’s going on here that I don’t know about.”

Imagine that you had just inherited $100,000 and you wanted to invest it in a savings account to get a return on your money. Further imagine that your town had two banks from which to choose. The first paid 8%, but you could not reinvest it. The second bank paid 5% on your initial deposit, but, unlike the first bank, it would let you reinvest your earnings at a rate of 12%. Finally, assume that each bank required a 25 year commitment and that your investment was insured and safe.

Which would you choose? Buffett used this example at the 1992 Berkshire Hathaway shareholders meeting to illustrate the way we should think about growth and value when considering a prospective investment. Buffett acknowledged that the example was a simplification, but that it nevertheless underscored the importance of understanding the basic mathematics of investing. (1)

So which would you choose? What if you needed to pay a $20,000 sales charge to gain access to the second offering?

(Pause, and think about your answer.)

It turns out that the net present value of the second account is double that of the first. Even though the initial rate of return at the first bank is 60% higher than that of the second, over time the ability to reinvest your earnings at 12% makes a huge difference.

If we equate these bank accounts to stocks, we can imagine the first bank being a stock selling at 1x book value with an 8% return on equity that pays out all its earnings in dividends. We can liken the second bank account to a stock selling at 2.5x book with a 12% return on equity. Because you would need to pay a premium to net worth of 2.5x, your earnings on your average carrying value would be reduced to 5%.

However, all retained earnings would earn a much more generous 12% and the compounding of those retained earnings at 12% would really add up over time.

The takeaway here is a greater insight into the power of investing in businesses that can generate a high return on incremental reinvested capital over the long-term (which are rare), even if you need to pay up to do so. It also illustrates the potential pitfalls of relying on a single valuation metric such as price to book ratios as a substitute for thinking deeply about the net present value of the dollars you lay out when you make an investment.

Finally, Buffett may not actually do a discounted cash flow analysis when evaluating an investment. Charlie Munger has said he’s never seen Buffett do one. Nevertheless, it seems likely, based on this example and others, that Buffett has done the math and has these types of models committed to memory which he can immediately draw upon when sizing up an investment.

Anyone who has studied Warren Buffett knows that he likes to make an analogy between hitting a baseball and investing. The great Ted Williams taught that in order to be a .400 hitter, a batter needs to be highly selective in the pitches he swings at. He divided the strike zone into 77 segments and would only swing at balls in those that offered a high percentage of getting a hit. Like Williams, Buffett teaches that to be a highly successful investor, you should only purchase stocks when the odds are highly stacked in your favor.

Unlike baseball, there are no strikes in investing (unless you are operating under an institutional imperative that, for example, requires you to be fully invested). You are free to wait – and wait – until you see the perfect pitch and then swing for the fences (back up the truck).

This framework obviously works best when you know exactly what you are looking for. Look at Ted Williams: he took the time to dissect the strike zone so he could focus on his “happy zone”.

So, what is your happy zone? Have you clearly defined what you will swing at – or, equally important, what you won’t swing at?

As an investor, it is important to have a good valuation methodology. To be a .400 hitter as an investor, you need to only purchase stocks where there is a large gap between what you pay and the value you receive, and you need to be able to quantify that gap. Of course, you need to be conscience of not falling into a trap of false precision, but if the value gap is sufficiently large, you’ll have downside protection of your capital and favorable odds of making a good return when the value gap closes.

Here’s the answer. “Not many companies will do that. You see a lot of garbage about EBITDA. Depreciation is the worst kind of expense in that it is prepaid. He looks at EBIT/EV. He’ll generally pay 7x for a decent business. For insurance companies, he looks at float and the cost of float.”

If you develop your own hurdle, then you will have another powerful tool in your investing tool box. Rather than just waiting for a fat pitch, you’ll improve your results by defining your perfect “happy zone” ahead of time. Then when you see it, you can load up.

There are two primary approaches to generating outstanding returns: 1) buy a stock that is selling for less than intrinsic value and 2) buy a stock that is growing intrinsic value at a high rate. Combining the two, as the hypothetical examples in the graphs show, can lead to significantly outsized returns.

The second graph shows the power of making intelligent repurchases of shares. This means purchasing shares when they are selling for less than intrinsic value. A close examination of a CEO’s track record for repurchasing shares can tell you a lot about his ability to allocate capital. Look to see whether shares are purchased when shares are over or undervalued.

The essence of Buffett’s investment process is putting out cash after careful consideration of the facts with the expectation of a reasonable (or better yet, unreasonable) return. He sees this as fundamentally different from speculation where the emphasis is not on what an investment is intrinsically worth but on what the next person will pay for it. Buffett does not think that there is anything wrong with speculating per se; it’s simply a game he chooses not to play. At the center of Buffett’s investment process is the ability to value an asset. To do this requires that you answer only three questions:

How certain are you that your investment will produce cash?

How much cash will it produce and when will it be paid?

What is the risk free interest rate? Buffett uses the yield on long-term treasury bonds for the risk free interest rate.

Buffett teaches that this basic framework is immutable and can be used to value any type of asset – farms, oil royalties, stocks, bonds, lottery tickets and manufacturing plants. An investor can use this framework to evaluate all available assets and then invest in the one that is the cheapest, that is, the one that that offers the most value for the dollars invested.

For an investment grade bond, making this calculation of value is easy, because the bond generates a fixed coupon that is contractually bound to be paid on a fixed schedule. However, when valuing a business, it is the investor’s job to estimate the amount and timing of cash that the business will produce. This is an inherently imprecise process, yet it can be very useful.

Even if an investor can only come up with a range of values for a prospective investment, such a range of values may allow the investor to make a profitable investment if the investment can be purchased at a price below those values. For example, if your best appraisal of a real estate investment was very imprecise, for example, that the property was worth between $1 million and $2 million, that estimate would still be very useful if you could purchase the property for $700,000.

Valuation is not primarily a question of how precise it is, but rather how certain it is, and whether you can purchase the asset cheaper than the lowest reasonable estimate of value. That is why Buffett’s first question is about certainty. Buffett thinks about risk first and will not invest in a business that he does not understand or that is subject to a lot of change because it makes the analysis of value impossible. Buffett once quipped that if he were teaching a class on investing, the final exam would include asking students to value an Internet company. Anyone who tried to answer the question would be flunked. It is simply too hard to value a business that is not producing cash in an industry where it could be obsolete in a year or two.

This is why Buffett looks for companies that have a durable competitive advantage – what Buffett calls a moat – because these types of businesses have predictable cash flows. The best evidence that a moat exists is a business that is profitably doing pretty much the same thing today that it was doing ten years ago, generates high returns on invested capital and is unlikely to succumb to the forces of creative destruction in the foreseeable future. Buffett looks for strong management that will work diligently to deepen the moat or, at least, work hard to minimize the effect of any forces that are eroding it. He also wants a business where management’s interests are aligned with those of shareholders. Even a business with strong predictable cash flows can be a poor investment if management is egregiously compensated or is prone to making poor capital allocation decisions.

If an investment fails to meet his standard of certainty, Buffett is happy to walk away. If he doesn’t understand a business or it is in an industry subject to rapid change, he won’t invest, knowing that to do so would be speculating.

When people go to Las Vegas they often think about their money in a way that is very different from the way they think about it in everyday circumstances. This is summed up nicely in the following joke I found at the Certified Financial Planner website (cfp.net). This joke is told by economists regarding a phenomenon in behavioral finance known as mental accounting. Mental accounting is the tendency to think about money differently depending on the circumstances.

“A husband and wife spend a night in Las Vegas, and the man decides to try his luck at the casino. He loves roulette, but vows not to wager more than $5. So he puts his $5 down — on his lucky number, 17 — and wins. He keeps betting on number 17 and he keeps winning, so much so that towards the end of the night he is up more than $10 million. He decides to wager it all one last time on number 17. But this time he loses, and his $10 million gain is gone in an instant. When he returns to his hotel room, his wife asks him, “How did you do?” “Not bad,” he replies. “I only lost $5.”

The man could afford to be so relaxed about his multi-million dollar loss because of a phenomenon known as mental accounting, the tendency to value money differently based on where it comes from, where you keep it, how you spend it, and whether you expected more or less of it. As far as the gambler was concerned, the only money that was really ‘his’ was the initial $5. He didn’t have the $10 million before he started gambling and he didn’t have it when he finished, so for him the only real loss he suffered was the $5.”

I believe a form of mental accounting can occur when a person buys a stock with a high P/E ratio, for example 25 or higher. Granted, as Buffett pointed out in his 1991 letter to shareholders, an outstanding business can be worth 25 times earnings. Here’s the passage:

“A few years ago the conventional wisdom held that a newspaper, television or magazine property would forever increase its earnings at 6% or so annually and would do so without the employment of additional capital, for the reason that depreciation charges would roughly match capital expenditures and working capital requirements would be minor. Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings, which meant that ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was propriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)”

Buffet has also said that when you buy a stock you should think about the same types of things you would think about if you were going to purchase a private businesses in your hometown. How is the business’s competitive position? Is the business growing or in decline? What will it look like in five and ten years? What factors could cause you to lose your investment? Here’s the point: if you found a business that was earning $1,000,000 a year in after-tax profits, it would have to be quite an extraordinary business for you to pay $25,000,000 to buy it. You would immediately think of how many things would have to go right for many years into the future just to get your money back and that’s without even including the effects of inflation. You would also think about how hard it would be to predict if the business would be going strong a decade into the future given the amount of factors at play.

Yet “investors” routinely purchase stocks at this multiple of earnings without much of a second thought. Perhaps many are really speculating. If you look at a discounted cash flow of the business in Buffett’s example, fully 67% of the cash comes after the 10th year. That is putting a lot of faith in your ability to predict the future with no margin of safety.

In a 2004 interview in The Motley Fool, Bruce Greenwald gives an example which drives home the importance of having the patience and discipline to average down in order to optimize performance. Greenwald talks about Paul Sonkin, who, at that time, had averaged about 25% after fees for the previous four and a half years.

Greenwald observed that Sonkin would often make additional pruchases if a stock declined after he bought it. Greenwald looked at Sonkin’s trades and determined that, of the 25% return, fully 22% was from purchases made after the initial purchase. Greenwald also notes that he was looking at the performance of legendary value investor Walter Schloss who averaged 15.3% over five decades. It appeared that much of Schloss’s returns came from the same practice and then selling on the way up. As Bill Miller says, “Lowest average cost wins.”

Takeaways:

Follow-up purchases that lower the cost basis in a stock can have a powerful impact on returns.

Caution! This strategy only works if you have a strong valuation methodology so you can avoid expensive “value traps” and “falling knives”.

This approach requires having a certain self-mastery coupled with a proper orientation on how to think about market prices. For that, study chapter 8 of The Intelligent Investor.

Graham thought that J.I. Case was an example of a situation where an analyst cannot reach a reliable estimate of intrinsic value.

He goes on to say that if the price were low enough, an analyst MIGHT be able to conclude that it was undervalued, for example at $10.00 per share.

Takeaways:

An analyst cannot assume that a regression to the mean will occur or that an average of past earnings will persist. There must be “plausible grounds” to support the analyst’s projection, particularly if it involves growth.

Some value investors will simply not pay for future growth, on the assumption that no such projection is reliable. Others, such as Buffett, are highly selective and will only invest in a growth company if, in addition to having good growth prospects grounded in facts, it also has a clearly entrenched competitive advantage.

Some companies should be put in the “too hard” pile. There are plenty of fish in the sea and time is valuable; don’t waste it on trying to figure out the unsolvable.

Be highly suspect of asset values, particularly of distressed companies. Sellers of newspapers in today’s market are receiving a cruel object lesson in the value of assets that can no longer produce profits. In his 1985 letter to shareholders, Buffett described what happened when he liquidated Berkshire Hathaway’s looms.

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo – or a single See’s candy store – considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.”

In conclusion, Graham’s notion of intrinsic value is a highly useful concept, if you use it correctly and understand its limitations. As Aristotle said, “It is the mark of an educated man to aim at accuracy in each class of things only so far as the nature of the subject allows.” Be patient and hold your fire until it’s obvious. There have been plenty of these opportunities in the past and there will be plenty in the future.

A lot of what passes for security analysis looks a lot like the Greater Fool Theory. Investopedia defines the Greater Fool Theory as, “A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” This approach is as old as Wall Street, and, although a (very) few traders may consistently make money using this approach (without the benefit of an advantage such as high-frequency trading), the average person cannot.

Against this backdrop, Benjamin Graham came along and introduced a powerful new idea into the field of security analysis. The foundational idea was that when you buy a stock certificate you are buying a small piece of a real business. And if that is the case, a person ought to be able to come up with some idea of what the business is worth by studying the facts: the assets, earnings, dividends, future prospects, management, litigation, etc. This is what Graham called intrinsic value. Graham further recognized that because of the enormous volatility in the stock market, it would be possible from time to time to purchase shares of a given stock at a clear discount to what the underlying business was worth. This discount not only provided a rational basis for the expectancy of a decent return (or indecent, depending on the level of undervaluation), but also afforded the investor a cushion of safety against errors in judgement and analysis, and unforeseen future events.

Graham points out that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values. If you can establish this range, you can then determine if the stock is undervalued, overvalued, or fairly valued. This lack of precision need not be a problem, if you can buy the stock cheap enough. By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age.

In Security Analysis (Sixth Edition) (pages 63-67), Graham gives two example of equities where he determines their intrinsic value.

Wright Aeronautical Corporation
Here is a profile of the company in 1922:
Share price: $8.00
Earnings: over $2.00
Dividends: $1.00
Cash per share: $8.00
Graham’s range of intrinsic value: $20 to $40

Observations:

Graham concluded the stock would be a bargain at $8.00 per share.

The low end of the intrinsic value range is at most 10x earnings and as low as 6x earnings if we assume that the company had no debt. (At $20 per share you would only be paying $12 per share net of cash.)

In no case would Graham estimate the value to be greater than 20x earnings ($40/$2).

Here is a profile of the company in 1928:
Share price: $280.00
Earnings: over $8.00 ($3.77 in 1927)
Dividends: $2.00
Net-asset value: $50.00
Graham’s range of intrinsic value in 1929: $50 to $80

Observations:

Graham thought that Wright Aeronautical might be worth as little as just over 6x its 1928 earnings. Graham may have looked at the earnings in 1927 and been unconvinced that the company could maintain earnings at the $8.00 level.

In no case would Graham pay more than 10x (what appear to be peak) earnings of $8.00 per share.

At $280.00 per share (35x 1928 earnings), Graham thought it was clear that Wright Aeronautical was overvalued.

Tomorrow I’ll take a look at J.J. Case Common and draw some conclusions for our use as contemporary value investors.

Buffett always allocates his capital to what he judges to be the optimal opportunity. He wants his capital in stocks that give him the greatest chance of success, which he defines as situations where there is a minimal chance of losing his capital and the greatest expected payoff. In 1958, when his stock in Commonwealth rose to $80 per share it was still undervalued given the $135 per share that Buffett estimated it was worth. However, he sold it because he could purchase another stock with an intrinsic value of $125 per share for $50. As Buffett wrote, “The relative undervaluation at $80 with an intrinsic value of $135 is quite different from a price of $50 with an intrinsic value of $125.” Buffett sold Commonwealth when its price rose to $80. In this case, Buffett chose an investment that was more undervalued than Commonwealth but not more so than other opportunities that were available to him. He chose it not only on the basis of its undervaluation, but also because he would be the largest shareholder in the new position which would give him the opportunity to correct the undervaluation and optimize his portfolio’s internal rate of return.

Takeaways:

Although transaction costs and taxes need to be given their due, don’t marry your stocks. Each holding should be regularly evaluated against your other opportunities.

You should be willing to sell an undervalued security to purchase another security of greater undervaluation or that is equally undervalued but safer.

The greater the level of undervaluation in your portfolio holdings the greater the expected return.

Given the time value of money, all other things being equal, you should prefer situations with an identifiable catalyst.

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